The Cap Rate Myths

The Cap Rate Myths

Brian Burke writes in BiggerPockets that “A lot of what you read about cap rate is simply wrong. I’m here to dispel the cap rate myths and tell you the real story.”

“Perhaps no topic is more overrated, misunderstood, or debated than cap rate. I would also argue that the capitalization rate has more inaccurate or misinformed articles written about it than pretty much any other topic on real estate.”

“Instead, why not just forget everything you’ve read about it, and start from scratch here?”

What are Capitalization Rates?

Investopedia describes capitalization rates (cap rate) as “the rate of return on a real estate investment property based on the expected income that the property will generate. We use the capitalization rate to estimate the investor’s potential return on his or her investment.

“The capitalization rates of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property, where NOI is the annual return on a property minus all operating costs. To calculate the capitalization rate divide the net operating income by the current market value:

“Capitalization Rates = Net Operating Income / Current Market Value”

The Cap Rate Myths

Myth #1 – “Cap rate is the return you get if you paid all cash.” Wrong, the cap rate is based on the purchase price, not whether you pay in cash. The cap rate tells you little about the expected return. You may immediately raise rents, and you may inject money on closing costs, title insurance, legal fees, immediate capital improvements to correct deferred maintenance—you name it.

Myth #2 – “I need to buy at a high cap rate to get the returns I’m looking for.” It may seem like that makes sense, but if the higher cap is in a slow growth, high unemployment area, the property will not perform better than a lower cap property in a rapidly growing environment.Myth #3 – High cap rates mean a good deal. “Even within the same market, you could have a property selling at an 8% cap rate that could be a worse deal than another property in the same market selling at a 6 percent cap rate.”

Myth #4 – Rising Interest Rates Mean Rising Cap Rates. Interest rates are only one of the many inputs to a cap rate. The bottom line is that cap rates compress and decompress at the whim of market sentiment. When real estate becomes less popular, prices go down, which means cap rates go up. When demand for real estate is high, prices go up, which means cap rates go down.Myth #5 – “I bought the property at a five cap and took it to a ten cap!” It could mean he drove the value into the ground. Besides, “boasting about moving the cap rate (which you based only on the purchase price) ignores the additional capital required to achieve the higher NOI. And of course, this says nothing of the fact that using post-acquisition NOI to calculate cap rate is bending the rules of the formula itself.

I have written about cap rates several times over the last few years. I always learn something new each time I explore the subject. I hope you do as well.

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